Conditioning Carry Trades: Less Risk, More Return!

Abstract

We propose an easy-to-implement conditional currency carry trade (CT) strategy that excludes regimes for which UIP is likely to hold, namely when interest rate differentials (IRDs) are very large during high foreign exchange (FX) volatility regimes. We find that conditioning a CT strategy on both FX volatility and extreme IRDs outperforms the base-case unconditional CT strategy in terms of mean return, holding period return, Sharpe ratio, and skewness in virtually any of the settings analyzed. Conditioning on high FX volatility only, or on very large IRDs only shows mixed findings. Our strategy works best for smaller CT portfolios.

Keywords: Carry trade, international finance, uncovered interest parity

JEL Classification: E43, F31, G11